This article discusses the housing outlook for 2007

2007 has commenced with a lot of mixed signals. Some research reports suggest that pricing declines will continue, others believe that the worse maybe over for the homebuilders. The truth lies somewhere between the fine print!

We believe that the housing market will be in ‘pause’ mode until Spring sets in. The economy has posted some impressive numbers, and we believe, some key factors that drive the housing market may be turning positive:

1. The economy has posted good numbers. Inflation is tame and the likelihood of a rate hike by the Federal Reserve looks low. These augur well for mortgage interest rates. Unemployment rate is low - salary and employment levels in markets ultimately dictate the health of that market, and a robust economy will prevent a severe downturn in the housing market.

2. A lot of the bad news from the homebuilders is now behind them. The pricing increases of the last few years saw homebuilders overinvesting, and as the housing markets have cooled over the latter half of 2006, the homebuilders have cleaned up their act. Although the number of unsold houses, and days on the market numbers look ominous, overall inventory on the market should decline leading to a reduction in ‘overhang’ in the housing market.

3. Most overheated markets will exhibit some year over year declines, but these declines will not eliminate the gains in equity for homeowners who bought their homes before mid 2005.

4. It will be a buyers market. If you can buy a home without a fancy mortgage such an Option ARM or a mortgage with an interest only option, this may be a good time to get a great deal on a home.

Ultimately, don’t believe the hype. Stick to the tip we posted in the first blog: Are you buying the home on the inherent economics underlying the purchase (monthly mortgage payments, price of home)  vs. affording a home based on your ability to qualify for a mortgage ? Are you willing to live in the home for the next 3-5 years ? If ‘Yes’, you should do okay with the purchase of a home…

This article examines some of the common errors folks commit when they run a rent vs buy analysis for home purchase.

A rent vs. buy analysis is one of the most important calculations that aspiring homebuyers should conduct, however, they should avoid these follies:

1. Monthly difference: Don’t determine the difference between buying a home vs. renting by simply calculating the difference between monthly payments and aggregating them over the period you intend to stay in your home. The correct comparison compares the cost of renting vs. net cost of buying a home. Include only the interest payment you expect to pay, remember, the principal is used to pay down the loan and goes towards the equity you build in your home. Determine the interest component of your mortgage payment (refer to an amortization table like the one on this website), add other monthly payments such as home owner’s insurance, hazard insurance, property taxes, home owner’s association dues etc to determine the gross monthly housing payments.  Since home purchase offers tax advantages, if available to you, don’t forget to back out the tax benefit associated with home ownership (mortgage interest, property taxes, points may be tax deductible if you can itemize them) from the gross monthly housing payments to calculate the net mortgage payments. Then, calculate the difference between the net housing payments and total monthly rental cost (rent, rental insurance, HOA dues etc)

2. Time value of investing the difference: Many calculators fail to factor in the ‘time value of money’. In normal speak, the ‘return’ on the difference determined in step # 1 above should be determined. For e.g. if the difference in month one is say $ 100. This is invested at 5% per year (your rate of investment) for 5 years (duration of stay at this home), marginal tax rate is 35%, then the expected future value less the initial investment ($100) will be calculated as : ( $100*(1.05)^5 - 100 )*(1-0.35) = 17.95. Thus, the return for all time periods beginning with month one until the last month of stay in the home should be determined. These should be aggregated as a benefit (if monthly house payments exceed rent payments) or as a cost (if monthly house payments are higher than rent payments) in the rent vs. buy analysis.

3. Other factors: You should also consider potential increases in your interest rate if you have an adjustable mortgage. Likewise, any anticipated increases in rent payments should also be factored in. A key factor in determining the equity built over time is anticipated increases (decreases) in house prices.

The ‘Free Calculators’ section features an excellent ‘Rent vs Buy’ calculator that considers all of the above factors. You can run model different scenarios for different home prices, loan amounts, home appreciation rates etc.

Buy a house on its inherent economics. Do not buy a house based on your ability to qualify for a mortgage. This article identifies the folly of the latter approach.

Lenders determine a home buyer’s affordability based on lending ratios. The two most commonly used ratios defined as the ‘front end’ and the ‘back end’ ratio determine the ratio of monthly housing payments to gross monthly income and ratio of total debt (mortgage, credit card, tuition etc) to the gross monthly income respectively. If homebuyers fall under these qualifying ratios guidelines, they may qualify for a mortgage. Most lending institutions adopt their own lending guidelines based on their goals, credit ratings, target customers (prime, sub-prime etc), and today, with the softness in the housing market, it may seem that you can always find a lender who is willing to offer you a mortgage. A few years ago, when ARMs and option ARMs were a much smaller percentage of total mortgage originations, a 36% debt to income ratio was accepted as the defacto industry standard, however, with the run-up in housing prices over the last few years, lenders have relaxed such qualifying ratios to capitalize on the housing boom.

As a homebuyer, it is important that you determine your affordability based on the inherent economics of your home purchase and not on your ability to qualify for a mortgage. Economists often site a high mortgage payment to income ratio as a sign of a ‘bubble’. In certain hot metro markets like the San Francisco Bay Area, such ratios have gotten out of whack. In such areas, with surging home prices, and an increase in the mortgage interest rate (30 year FRM) from 2005- mid 2006, homebuyers are ‘stretching’ to qualify by opting for more exotic mortgages on the ‘mortgage totem pole’. You start with a 30 year fixed rate mortgage that typically carries the highest interest rate (Some lenders are also offering 40 year and 50 year mortgages, but they are excluded from this article as these loan programs are relatively new and comprise a miniscule % of total mortgage originations), and if you don’t qualify for it you slither down the ‘totem pole’ : 30 year fixed rate mortgage with interest only option, ARMs, ARMs with interest only options and option ARM with negative amortization until you find a program you qualify for. By doing so, you have bought a home not on the inherent economics (we will discuss that below), but on your ability to qualify for a loan program.

As a homebuyer, it’s important to determine affordability based on your pocketbook. Can you make the mortgage payments without compromising on your quality of life? Can you balance your checkbook? Do you believe your home will appreciate over a 3, 5 year period? Can you ride out a decline in home prices ? The hype from the realtor aside, how much would you ‘really’ pay for this house?

The bottom line: Affordability calculators are useful, but use them only as a guideline. Start with your net income (gross income less taxes, social security, Medicare, retirement and other deductions), back out your mortgage payments, other debt payments and expenditures and stare at the balance. Are you comfortable with it? Are you saving enough to meet the needs of your family? If so, go ahead and buy.